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Basic Economics

Elasticity of Supply and Demand

What happens to the quantity demanded when the price of a good changes? If quantity changes a lot, we say that demand is elastic and stretches. If quantity changes only a little, demand is inelastic and the quantity does not stretch much. The "price elasticity (E)" of demand is equal to "% change in quantity demanded" divided by "% change in price".

When the value of E is equal to zero, demand is perfectly inelastic. If E is between 0 and 1, then demand is inelastic. When the value of E is equal to one, demand is unit elastic. If E happens to be greater than one, then demand is elastic. If E is equal to infinity, then demand is perfectly elastic. Note that although price and quantity demanded move in opposite directions, elasticity will always be positive by convention.

Determinants of Elasticity

Many factors influence elasticity, some of which include:

  1. Necessities versus Luxuries - It is harder to find substitutes for necessities so quantity demanded will change less.
  2. Availability of Close Substitutes - If there are close substitutes, buyers will move away from more expensive items and demand will be elastic.
  3. Definition of the Market - The more broadly we define an item, the more possible substitutes and the more elastic the demand.
  4. Time Horizon - The longer the time available, the easier to find substitutes and the more elastic the demand.
  5. Relative Size of Purchase - Purchases which are a very small portion of total expenditure tend to be more inelastic, because consumers are not worried about the extra expenditure.

Total Revenue and Elasticity

Raising the price will have two effects: more revenue per unit sold and; fewer units sold. In order to increase total revenue, we must decide which of the two effects is greater. When demand is inelastic, total revenue is more influenced by the higher price and increases as price increases. When demand is elastic, total revenue is more influenced by the lower quantity and decreases as price increases.

Income Elasticity of Demand

There are factors other than price that influence the demand for a product. Income elasticity of demand is calculated as the percent change in quantity demanded divided by percent change in income, ceteris paribus. There are two possible relationships. If demand increases when income increases, elasticity is positive and good is normal. If demand decreases when income increases, elasticity is negative and good is inferior.

The main influence on income elasticity of demand is whether a good is a luxury or a necessity. When goods are luxuries, elasticity is usually highly positive (greater than one). When goods are necessities, elasticity is usually lower (less than one). When goods are very basic, they can even be inferior (less than zero), such that demand falls when income rises.

Elasticity of Supply

This is a measure of how much quantity supplied (QS) reacts to a change in prices. Elasticity of Supply is equal to "percent change of QS" divided by "percent change in price". This value can range from zero to infinity. When elasticity is less than one, supply is inelastic. If elasticity is greater than one, then supply is elastic. The main determinant of supply elasticity is length of time. The shorter the time period, the more inelastic the supply, because it is harder to get the additional inputs to increase production. It also depends on whether the firm is near its capacity.